Reverse Due Diligence On Investors: A Crucial Step In The Fundraising Game

Reverse due diligence is increasingly becoming one of the most crucial steps in the funding process. Traditionally, due diligence has been the investors’ prerogative, where they go through the company’s financials with a fine-toothed comb. Any red flags can potentially result in the deal falling through.

However, the fundraising game now has a contrarian view–reverse due diligence, where founders delve into potential investors and their backgrounds. This reverse paradigm is about ensuring that they partner with the right people and avoid future clashes.

Bringing in investors is no longer just about capital. It’s a long-term collaboration that participants should enter into based on mutual goal alignment and shared values. Founders are wary of accepting capital that is accompanied by non-compliance issues and questionable behavior.

Considering the growing number of hostile takeover threats, dirty term sheets, and loss of reputation, you should do your homework. Just as investors scrutinize your company’s documents and other data before offering capital, you’ll examine them and their activities.

Going through their background and objectives with a magnifying glass effectively levels the playing field. Check for any potential risks that can create hurdles in the long-term success of your company.

Understanding What Reverse Due Diligence Is

Reverse due diligence is where founders run extensive background checks on their investors when compiling a list of potential targets. Before approaching them, you’ll validate their track record with backing companies similar to yours and their operating methods.

Most importantly, you’ll clarify the investor’s objectives for offering capital and their expected returns. Ultimately, all investors are concerned with the profits they can earn from an investment opportunity. What’s important is how they go about maximizing their gains and the added support they provide.

Read ahead to understand how to conduct reverse due diligence as part of your fundraising strategy.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Peter Thiel, Silicon Valley legend (see it here) that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

Run Background Checks by Tapping into the Community

Your reverse due diligence should start by gathering information about the investors. Here’s what you need to do:

• Start by reaching out to other investors within your network. Most venture capitalists (VC) and angels have close links with their peers and members of the community. You can request information about specific players and their operations.
• Connect with other entrepreneurs and founders who have worked with these investors in the past. Or, are currently in partnership with them. Inquire about the typical investment terms and conditions they expect.
• Most VCs have a portfolio page on their websites where they list the past projects they’ve backed. As part of the reverse due diligence, consider engaging in informal conversations with the founders. Asking questions about their experiences with their partners should give you a fair overview of what to expect.
• Don’t hesitate to ask your target investors for references. Most are open to building new connections and growing their network.
• Doing a social media search can also bring you valuable information, as can a simple Google search. Positive or negative–any article or post can shed light on your partners.
• Running a search on professional sites like LinkedIn can give you extensive information about their careers and experience. Remember, you need to collaborate with people who have a successful track record operating within your sector.
• Although meeting with target investors in formal networking events and conferences is the norm, take it one step further. Meet up with them in informal settings like a sports event, game, or non-profit fundraiser. Observe their demeanor and get insights into their thought processes.
• View investors as potential mentors and advisors who can help steer your company during crises like economic downturns and pivots. This reverse due diligence will prove invaluable down the line.

Verify Identity and Credentials

When creating a list of potential investors to target, you’ll ensure they are accredited with legitimate investment intentions. Start your reverse due diligence by checking sites like AngelList for more data. Here, you can verify their credentials and their capability to invest in private companies.

A verified accreditation status means that they meet specific criteria, including a net worth of over $1M, excluding residential property. They should also have an annual income of over $200K as an individual or $300K with a spouse or partner. This income should be consistent over the last 2 years.

Accredited investors should also have adequate financial expertise and experience to make sound investment decisions. Use professional websites like LinkedIn to verify their claimed achievements and contact details, including an official email address and phone number.

Running a credit and criminal check for nefarious activities should also feature in your reverse due diligence measures. Be wary of investment scams, particularly if you’re approaching offshore entities for capital. Partnering with bad players can cost you a lot more than just loss of reputation.

You also risk loss of shareholder confidence and adverse public opinion because of your association with them. Don’t overlook the possibility of conflicts of interest resulting in expensive litigation and court cases. You’ll have trouble attracting other investors down the line, also.

As an extension of your verification strategy, delve into the check providers. Aside from validating the investors’ identity and background, you’ll ensure that their funding stream comes from legitimate sources. Confirm that the money has gone through extensive anti-money laundering checks.

Your reverse due diligence will include learning more about the investor behind the scenes issuing the checks. And, the ultimate beneficiary of the profits and returns. Be wary of toxic money.

What are you looking for?

• Articles and media reports on reputable public forums about failed projects and disputes with legal or business partners
• Allegations of financial crime, like corruption, money laundering, or bribery, have been verified for authenticity.
• Mentions of blacklisting in official government gazettes and public announcements.
• Involvement in litigation and bankruptcy proceedings
• Instances where a company’s stakeholders have suffered reputational and commercial risk because of their association with a particular investment firm. These stakeholders can include customers, business partners, suppliers, vendors, investors, or other entities.

When you’re building a list of potential investors, platforms like LinkedIn are a great place to start. Not sure how to find good options? Check out this video where I explain how it’s done.

Validate the Investor’s Financial Status

Now that you have a fair overview of who the investors are, the next step is delving into their finances. Your reverse due diligence should start at their official website, where you can find extensive details.

• Search for the typical sectors in which they invest and their experience with successful projects.
• Ensure that your partners can contribute a fresh perspective for running the startup, and also provide networking opportunities.
• Reputable investors may list their check sizes as well as exit strategies and timelines. For instance, a seed-stage startup needs investors who are interested in longer holding periods. If they intend to liquidate their holdings within the next five years, you may want to rethink collaborating with them. The new investors and their goals may not align with yours.
• Research the typical growth stages that the investment fund backs. For instance, if it focuses on growth-stage companies and invests millions of dollars, it may not consider seed-stage startups.
• Typically, venture capital and other investment funds have limited partners (LP) on board who commit to investing certain sums. The general partner (GP) managing the fund calls on the LPs for further contributions. Before approaching a fund, you’ll confirm that it has adequate funds for investing or can raise them per your needs. Also, confirm how quickly you can get money in the bank. If the fund has already invested a major chunk of its capital, you’ll turn your attention to other sources. That’s a crucial step in your reverse due diligence process.
• Adequate funding is also crucial because you might have to approach existing investors for follow-up capital. Tapping ongoing partnerships for support is always preferable to running a fresh fundraising campaign. You’ll save on time, resources, and the risk of bringing in unknown entities.

Validate the Investor’s Expertise

You’ll notice that the industry-specific expertise comes up multiple times throughout this post. We can’t stress this crucial aspect enough for several reasons. Investors who work within your sector have an extensive understanding of its challenges and trends.

You need partners who recognize the potential of the products you’re developing. They should be able to assist you with hiring talent for an ideal product-market fit and advise you on the best marketing strategies. Above all, you need partners who won’t pull out at the first sector-centric downturn.

Strategic partners see you through the crises, offering additional funding and guidance to navigate the problems. Keep in mind that not all investors are interested in being involved in the day-to-day company management. But if you need this assistance, your reverse due diligence should factor it in.

Of course, you’ll also set clear boundaries when drawing up the terms and conditions of the funding deal. You’ll ensure that the optimum balance is maintained between sound advice and founder autonomy when making decisions for the company.

Expertise about the company’s growth stage is another crucial factor. Different growth stages need not only varying levels of capital, but also unique risks and decision-making. Your partners should be able to understand possible outcomes and not push the startup toward premature acceleration.

This is where you again need a clear alignment of goals. Investors wanting to make a quick exit will push for decisions that benefit them and their investment horizons. Check with other entrepreneurs who have partnered with them to understand how they operate.

This information will also come in handy when you form new partnerships as the company grows. Focus your reverse due diligence on avoiding the risk of disagreements between current and new investors. The possible conflicts of interest can cause problems.

Conduct Reverse Due Diligence into the Fund’s Internal Processes

Gather detailed information about the fund’s internal processes and mechanisms for investments. Here’s what you need to know:

• How do the screening procedures work for startups?
• Who are the key decision-makers and how do they operate?
• Does the approval process involve multiple steps and tiers in the organization?
• How long does their due diligence take?
• What is the typical time frame before decisions are finalized? You’ll base your estimates for getting money in the bank on these factors.
• Who is the specific general partner or other individual responsible for interacting with you? In other words, who is the point of contact? Can you build a good rapport with them?
• What does the reporting structure look like?
• What is the fund’s investment policy?

Your reverse due diligence into the investment firm will reveal details about the typical terms and conditions they offer. These can include profit sharing, equity, other classes like preferred shares, and voting rights. Also, inquire into the possibility of the firm appointing a representative to the board.

One of the most crucial factors is how the firm conducts valuation. If the investor’s proposed startup value is too high or too low, that can jeopardize future funding rounds. You’ll need the valuation to be fair, taking into account the assets, geographical location, team, and industry benchmarks.

A higher valuation will enable you to raise more funding, which is crucial for reaching the company’s following milestones. You can accelerate growth by investing in research and development, hiring new talent, and improving sales and marketing approaches.

Investors should understand how these benefits outweigh the risks of dilution and provide you with the capital you need. This capital infusion should be adequate to take the company to the next level.

Why Reverse Due Diligence is Crucial

Conducting detailed checks on investors has become crucial in the contemporary business sphere. Founders and entrepreneurs no longer view investors as just sources of capital. Instead, they are looking for strategic partners who understand the sector and business and can offer support.

Understand that different classes of investors now operate in the economic ecosystem with varying objectives, fund sizes, and investment horizons. Your job is to align their goals with your company’s mission and values.

Essentially, you’re looking for entities that are as committed to your company’s long-term success as you are. And those who are willing to provide the necessary resources to help you get there. Remember that every investor in the cap table is a vital stakeholder in the company’s framework.

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